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Big Bank Derivative Bets Nearly Double In Six Years

America’s major banks now hold derivatives with a notational worth of $225 trillion – about a third of the world total. No kidding. Trillion.

And that’s up from a mere $120 trillion six years ago. Rather than being weened off derivatives, America’s big banks are more deeply entrenched then ever.

Hopefully Wall Street has it figured out just right and there won’t be any major losses, say a few billion here or there. After all, when has Wall Street ever been wrong about financial instruments?

“Derivatives are dangerous,” says Warren Buffett. “They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.”

While many in Washington would like to limit derivatives trading, make such trades open to public scrutiny or both, Wall Street is vehemently against regulation.

In fact, there’s a simple way to resolve derivative worries. Allow unlimited derivatives trading — but only by individuals and partnerships willing to personally take the risk of profits and losses.

What’s A Derivative?

In basic terms a derivative is a bet tied to the movement of anything that can be valued. We could have a derivative bet which says the price of a mortgage-backed security (MBS), Hungarian currency or lemonade indexes will go up by a certain date. If the value rises then one party to the derivative will make money and the other will lose. And vice versa.

Notice, however, that derivatives are not like stocks or bonds — or mortgages or home loans.

First, unlike mortgages there’s no limit to the size of a derivative bet or the size of the derivative marketplace because none of the bettors actually are required to own the underlying asset. For instance you might bet that the price of oil will rise or fall without owning a single drop. The bet concerns the movement of value and not the ownership of the oil.

Second, there’s huge leverage because not much cash is needed to enter into a derivative agreement.

Third, if you bet on a derivative you typically make an off-setting bet to limit risk. Hopefully you do it right.

$648 Trillion

According to the Bank for International Settlements (BIS), the notational value of derivatives at the end of 2011 was $648 trillion.

The gross credit exposure from these securities was believed to be $3.912 trillion according to the BIS — that’s up from $3.5 trillion at the end of 2009.

But what if the estimates are wrong? For instance, let’s say losses are just one tenth of one percent bigger than expected. Not a big deal, except in the context of international derivative levels that’s more than $640 billion.

Do taxpayers have exposure? You bet. According to the FDIC, at the end of June 2012 all depository institutions held derivatives with a notational value of $224,998 trillion. However, such bets are not spread across the entire banking system. Banks with at least $10 billion in assets hold virtually all derivatives, securities with a notational value of $224.803 trillion. While the FDIC insures deposits in some 7,200 banks and savings associations, only 59 FDIC-insured institutions have deposits of more than $10 billion. Your little community bank, savings association or credit union likely has no derivatives department.

Social Benefit

Derivatives are simply bets. They finance no factories, no research, no colleges, no homes and no cars. Any jobs they produce are incidental and inconsequential relative to the potential risk they represent, the risk that credit exposure has been incorrectly figured by hundreds of billions of dollars if not more. Since big banks hold virtually all derivatives, and since taxpayers can face massive costs if big banks fail, it follows that something should be done to limit taxpayer risk.

“In banking,” said Buffett in 2003, “the recognition of a ‘linkage’ problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a ‘chain reaction’ threat exists within an industry, it pays to minimize links of any kind.”

How can we control derivative worries? If they’re so necessary and safe, let bankers and traders take the risk. Personally.

This can be done with regulations which restrict the ownership of derivatives and derivative interests to individuals and partnerships. Federally-regulated banks, savings associations and credit unions would be prohibited from originating, buying, selling, brokering, owning, trading, holding or financing derivative interests, directly and indirectly, for themselves or for another party.

Such rules, of course, would apply to regulated financial institutions as well as their subsidiaries and partnerships, both in the US and abroad. And the regulations would also apply to financial products which fit within the definition of a derivative, even if called something else.

Under this system, derivative profits would be owned entirely by individuals and partnerships. And derivative losses? They too would be owned entirely by individuals and partnerships. No longer would taxpayers be forced to pick up the pieces if something goes wrong.

For those who believe in less government regulation here’s your chance….

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This posting has been updated and expanded from material published originally by the author on the Huffington Post.

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Why The Buffett Rule Is Just A Start

Should the incomes of the rich and famous be taxed on the basis of the Buffett Rule? That’s the latest question on the political front, a question which explains just how distorted our political conversation has become.

The Buffett Rule would tax incomes of $1 million or more at the rate of at least 30%. The Tax Policy Center estimates that 116,000 households would face higher taxes by 2015.

According to the Census Bureau in 2010, the latest year for which we have figures, there were 117,538,000 households. The number of households impacted by the Buffett Rule would be, oh gosh, about one per thousand. In other words, a minority of the top 1 percent, the upper crust of the upper crust.

The idea of a higher effective tax rate for the rich comes in part from Warren Buffett, the Nebraska-based billionaire who says his tax rate is lower than his secretary’s. Under the Buffett Rule if you make $1 million or more you could expect to pay an additional $170,000 according to the Tax Policy Center. That figure suggests that without the Buffett Rule high-income households now have an effective tax rate of just 13% ($1,000,000 x 30% = $300,000. $300,000 less $170,000 = $130,000 or 13%.)

So now the Buffett Rule is at the center of a huge debate: should millionaires and billionaires pay at least a 30% tax rate? If you think about it the whole question is strange for several reasons:

First, the government has a massive deficit. A major reason for that deficit is a lack of tax revenues. Some applaud the government’s financial problems, seeing smaller tax revenues as a way to “starve” the national government. Of course, they don’t seem to object to the paved roads that run outside their homes or the security of living in a nation where your money is safe.

Second, the argument is made that one reason taxes are so high on the poor and middle class is that 100% of their income is typically subject to Social Security taxes. The solution to this problem is to apply the Social Security tax to all income, including dividends, interest and capital gains. After all, if there is no income test to receive Social Security then why should some forms of income be excluded from taxation? Why should a dollar earned on the factory floor be taxed higher and effectively worth less than a dollar from dividends or interest?

Third, worries about a 30% tax rate for our financial elite are laughable. Under President Reagan the top marginal rate was 69% and it was 92% under President Eisenhower, 91% under Kennedy, 77% under Nixon and Johnson, and 39.6% under Clinton.

The Reagan Tax Increases

Reagan, according to Bruce Bartlett, agreed to least 11 tax increases during his presidency. Mr. Bartlett, by way of background, was a senior policy analyst for President Reagan and deputy assistant secretary for economic policy at the Treasury Department during the administration of President George H.W. Bush.

The Buffett Rule should be regarded as the first step in an effort to balance the nation’s finances before there are no finances to balance. Happily, Mr. Buffett and many in the upper brackets understand that paying taxes is not unfair, that they won’t miss a meal and that a functioning federal government and working social contract benefit everyone.

The Social Contract

The social contract? Yes. This is why the rich from all over the world come to the US. As Barron’s explains:

“Any private banker will tell you, that as soon as a centa-millionaire in Moscow, Beijing or São Paolo makes their fortune, the first thing they do is figure out how they can ferret away large chunks of that wealth to countries that guarantee political and personal freedoms, have sound legal systems, a favorable tax environment, good security and good schools for their kids. Those last two items are not to be underestimated. When asked what was the most important factor drawing them to a city, 63% of the globe’s super-rich said ‘personal security’ and 21% said ‘education.’

“Being wealthy in Russia or China or Colombia or Egypt,” said Barron’s, “comes at great personal risk. If a wealthy businessman falls afoul of politicians in any of these countries, or attracts the attention of gangsters, it’s in the realm of very real possibilities that they will get a midnight knock on the door. Best to have a bolt-hole beyond the reach of the local thugs, political or otherwise.” (See: Why London, New York Draw the Wealthy, March 30, 2012)

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Will Worse Gas Prices Raise Mortgage Rates?

Gas prices are rising in the US and it makes you wonder: will mortgage rates soon be rising as well?

The questions are not unrelated. In basic terms the price paid for gasoline at the pump has very little to do with the actual cost of production, refinement and distribution. However, the price paid at the pump is a universal tax of sorts, raising the cost to commute and move goods. In other words, higher energy prices add to inflationary pressures.

Mortgage Rates

When inflation hits economies then mortgage investors want to preserve the buying power of their capital. They do that by seeking higher home loan interest rates. If enough investors will hang onto their funds until rates rise then, as a self-fulfilling prophecy of sorts, rates go up.

Many think that higher gas prices are now the result of supply shortages or excess demand. It’s not true.

“It’s not a supply problem,” says Brian Williams on the NBC Nightly News. “Right now there’s plenty on hand and it’s not a demand problem we’re using much less gas than we do during the summer months. The problem is that prices are largely set by commodities traders, also known these days as speculators.”

According to the US Energy Administration (USEA), “U.S. dependence on imported oil has dramatically declined since peaking in 2005. This trend is the result of a variety of factors including a decline in consumption and shifts in supply patterns. The economic downturn after the financial crisis of 2008, improvements in efficiency, changes in consumer behavior and patterns of economic growth, all contributed to the decline in petroleum consumption. At the same time, increased use of domestic biofuels (ethanol and biodiesel), and strong gains in domestic production of crude oil and natural gas plant liquids expanded domestic supplies and reduced the need for imports.”

If US dependence on foreign energy has declined then why do prices increase? Some possible reasons include:

  • Less refining capacity (Actually, the country has excess refining capacity — we hit a 29-year high in 2011)
  • Shipping interruptions (think of Iran) and
  • Increased consumption caused by an expanding economy both in the US and abroad. (An expanding economy would make higher energy prices both tolerable and politically acceptable.)

Speculation

There is another reason gas prices rise and fall: speculation, bets that prices will move one way or the other. As Warren Buffett explains in his 2011 letter to Berkshire Hathaway shareholders:

“A few years back, I spent about $2 billion buying several bond issues of Energy Future Holdings, an electric utility operation serving portions of Texas. That was a mistake – a big mistake. In large measure, the company’s prospects were tied to the price of natural gas, which tanked shortly after our purchase and remains depressed. Though we have annually received interest payments of about $102 million since our purchase, the company’s ability to pay will soon be exhausted unless gas prices rise substantially. We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year.

“At yearend, we carried the bonds at their market value of $878 million. If gas prices remain at present levels, we will likely face a further loss, perhaps in an amount that will virtually wipe out our current carrying value. Conversely, a substantial increase in gas prices might allow us to recoup some, or even all, of our write-down. However things turn out, I totally miscalculated the gain/loss probabilities when I purchased the bonds. In tennis parlance, this was a major unforced error by your chairman.”

As I read his letter, it appears that Buffett bought his notes from the originating company and thus they could employ his cash digging wells and improving their system, but many investors simply buy and sell commodity and derivative interests in oil, gas, propane and such with no thought of delivery. For them commodities are simply a gamble that does not result in a single new well, refinery, efficiency or job.

Three Steps To Hold Down Gas Prices

So, how do we deflate energy speculation and thus hold down mortgage rates?

First, we get supply-rich Saudi Arabia to increase crude production — as they already have done!

Second, we learn how to jawbone, how to make bets against the US more risky. The way to do that is to follow the suggestion of Sen. Charles Schummer (D-NY) who says it’s time to open the strategic oil reserves just a touch.

Given that this is a political year and high gas prices hurt incumbents, it’s hard not to imagine that the strategic energy reserve will soon be opened just enough to drive down the high prices caused by speculation.

Third, we keep buying cars with better mileage, whether gas, electric or diesel.

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America’s Big Banks, America’s Financial Vietnam

Three years ago the most-powerful instutitions in America were the nation’s largest banks and brokerages, Wall Street for short. While millions of people were losing their homes, their jobs and their savings, the nation’s elite extracted a $700 billion line-of-credit from Uncle Sam.

Now Wall Street is our financial Vietnam. It’s broken. The old cures and postponements won’t work. Everyone knows it.

“High risk mortgage lending and shortcomings in consumer protections for mortgage borrowers were among the most important underlying causes of the housing bubble and the financial crisis that resulted,” according to Sheila Bair, past chairman of the FDIC. “Not only did the proliferation of high-risk subprime and nontraditional mortgage products help to push home prices up during the boom, but excessive reliance on foreclosure as a remedy to default have helped to push home prices down since the peak of the market over four years ago.”

No longer are huge financial corporations seen as too big to blame — nor as too big to fail. In fact, some have even embraced the idea of a voluntary bankruptcy.

  • Stock values for the financial sector are in the dumper. Shareholder equity worth hundreds of billions of dollars has been destroyed.
  • The value of savings has been demolished with interest rates at record lows. Those who had played by the rules and put away for retirement now find themselves with pension cash that generates only tiny dribbles of income and surely less than the rate of inflation. In effect, savers are losing buying power. Many who were once financially comfortable are comfortable no more. Government, corporate and private pension plans have all been decimated.
  • According to the FDIC the banking industry had profits of $28.8 billion in the second quarter — after reducing reserves for loan losses by $21.5 billion when compared with a year earlier.
  • Large and growing demonstrations are taking place in New York, Seattle, Boston and Washington. Groups such as Occupy Wall Street, Occupy Together.org, Occupy DC and TakeBackBoston are rising with the speed of Twitter, texting, Facebook and Google.
  • A huge march for jobs and justice is scheduled for October 15th in Washington. Major unions and other organizations will be involved, according to the National Action Network.
  • Sweetheart deals between banks and regulators are falling through. The Federal Housing Finance Agency is now suing 17 major banks and servicers, alleging that mortgages worth nearly $200 billion were sold to Fannie Mae and Freddie Mac through “negligent misrepresentation.”
  • An effort to paste together a $20 billion robo-signing settlement between several major banks and the nation’s 50 attorneys general is on the rocks. Several state AGs — including New York’s Eric Schneiderman and California’s Kamala Harris — oppose a general settlement which would allow banks and servicers to avoid further mortgage and securities investigations.
  • Michael Hudson, author of The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America–and Spawned a Global Crisis, alleges that lenders have “protected fraudsters by silencing whistleblowers” in his new two-part series, The Great Mortgage Cover-Up.
  • The real size of the 2008 bailout is beginning to be understood. It wasn’t just a $700 billion line-of-credit, it was also secret funding worth $1.2 trillion according to Bloomberg News. “The largest borrower, Morgan Stanley (MS), got as much as $107.3 billion, while Citigroup took $99.5 billion and Bank of America $91.4 billion,” says Bloomberg, which had to sue to get the information. (See: Wall Street Aristocracy Got $1.2 Trillion in Secret Loans, August 22, 2011)
  • Across the country foreclosures have slowed, not because there are more jobs or better times but because the electronic sale and transfer of mortgage notes is widely regarded as unreliable. As the Maine Supreme Court explained to one lender, their documentation was “inherently untrustworthy.”

Gutting Regulation

In even in past periods when unemployment has been high there was no mortgage meltdown that compares with what we have seen since 2007, the year home prices peaked.

So what happened?

The presidency of George W. Bush was powered in large measure by an effort to reduce both taxes and government regulation. The compassionate conservatism he promised — whatever that was — quickly was replaced with the thinking of Ayn Rand.

“When I say ‘capitalism,’” said Rand, “I mean a full, pure, uncontrolled, unregulated laissez-faire capitalism — with a separation of state and economics, in the same way and for the same reasons as the separation of state and church.”

Indeed, officials from five financial regulatory agencies told reporters in 2003 they were going to “identify and eliminate outdated, unnecessary or unduly burdensome regulations imposed on insured depository institutions.” To make sure no one misunderstood, four of the regulators stood around a pile of paperwork with pruning shears. The fifth, James Gilleran with the Office of Thrift Supervision, posed with a chainsaw.

The Securities and Exchange Commission decided in 2004 that 11 major banks and brokerages could have more liberal reserve requirements than competitors. The SEC said “the 11 firms we expect to apply under the rule amendments could realize a total reduction in haircuts of approximately $13 billion. We estimate that they will realize a total annual benefit of approximately $26 million (.2% * $13 billion = $26 million).”

How nice to give selected corporations a $26 million advantage. That sure sounds like a case of the government picking marketplace winners.

In fact, according to The New York Times, much more that $26 million was involved.

“The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.” (See: Agency’s ’04 Rule Let Banks Pile Up New Debt, October 2, 2008)

Federal Monopoly

In 2004, one major bank regulator, the Office of the Comptroller of the Currency (OCC), simply ruled that state regulators had no right to oversee national banks in any meaningful way. According to Eliot Spitzer, then the attorney general of New York:

“The OCC today issued two regulations designed to protect national banks at the expense of consumers.

“One regulation would broadly preempt all state laws against national banks, including predatory lending laws, leaving only narrow exceptions for contracts, debt collection, acquisition and transfer of property, taxation, criminal, zoning and tort laws.

“The other regulation would confer upon the OCC exclusive jurisdiction over national banks, and specifically exclude state attorneys general from enforcing consumer protection laws against national banks.

“Together, the two regulations would prevent the states from enacting or enforcing almost any law against national banks, including consumer protection laws of general applicability that apply to every other business in the state.

“These regulations would also result in an unprecedented expansion of the OCC’s powers, while at the same time shielding the banks from state enforcement officials charged with protecting their citizens from fraudulent and illegal conduct.

“The OCC regulations are opposed by a bi-partisan coalition of state officials. In fact, all 50 state attorneys general have submitted comments to the OCC opposing this action. The attorneys general have noted that OCC devotes the vast majority of its time and resources to monitoring the safety and soundness of financial institutions, and does not have the states’ experience, expertise, resources or record in addressing consumer protection issues.”

Spitzer was exactly right.

The truth is that the mortgage meltdown was entirely preventable. The Federal Reserve, under the Home Ownership and Equity Protection Act, has the unilateral right to ban mortgages and mortgage activities which it defines as “unfair and deceptive acts or practices.” Under the chairmanship of Alan Greenspan — a long-time Rand devotee — the Fed never used its power to stop option ARMs, interest-only mortgages or no-doc loan applications.

Think about it:

If the mortgages were good then the mortgage-backed securities (MBS) would be good. If the mortgage-backed securities were good then the banks and brokerages would not have massive losses, mortgage investors would be whole, the companies that “enhanced” (insured) mortgage-backed securities would be profitable, and people across the country would not be losing their homes because they financed with “nontraditional” loan products that included surprise terms, prepayment penalties and huge monthly cost increases. And if the housing sector was okay then home prices might well be stable and many of the job losses we have today would never have happened.

There’s little doubt that many will discount the marches and tweets now growing in volume and fervor. That’s a mistake. In the same way that the Vietnam war became unsustainable as political support waned, that’s now happening with the policies, tax breaks and favors for big banks, big brokerages and big corporations. It’s our new financial Vietnam and like the first one it has cost great treasure, weakened our economy, hurt our national interests and devastated the social contract.

“There’s class warfare, all right,” Warren Buffett told the New York Times, “but it’s my class, the rich class, that’s making war, and we’re winning.”

I disagree. It’s not the “rich” it’s the greedy. There are a lot of rich people — including Buffett, Bill Gates and even JPMorgan Chase CEO Jamie Dimon — who understand that higher taxes are a cheap price to pay for social consensus.

It’s also in a large sense not a left-versus-right or conservative-versus-liberal debate. Rather there’s a growing understanding that Albert Einstein was right when he said “the thinking it took to get us into this mess is not the same thinking that is going to get us out of it.”

Moreover, it’s hard to see that there are many winners. If you don’t believe it just look at the Bank of America — it’s downsizing and planning to lay-off 30,000 workers.

There is an answer. Big financial institutions need to be smaller so there’s less risk to us all. Repeal the Gramm-Leach-Bliley Financial Services Modernization Act and bring back Glass-Steagall, a 1933 law which said that a bank could make loans and collect deposits or it could raise money and sell securities — but not both. Require financial institutions to have a 5 percent cash reserve for every derivative they buy, sell, finance or insure — for themselves, for others or for a subsidiary. Limit the size of depository institutions to $100 billion in assets. Limit the size of branch networks to a maximum of ten states. Prohibit commercial banks from selling insurance or annuities. Limit ATM charges to $1. Allow state bank regulators to define predatory loans and enforce their definitions even when national banks, thrifts and credit unions are involved.

The list goes on but the point is obvious: A financial institution which can undermine the entire economy of the United States is not just too big to fail, it’s also too big to regulate and too big to exist.

Financial holding companies can divest divisions and subsidiaries until they’re rightsized, downsized, focused, leaner, more efficient and more profitable; a better deal for customers, clients, employees and shareholders. The businesses that are sold off can keep their employees and function independently — and sink or swim on their own without needing or expecting a taxpayer bailout.

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Ready For The 3 Percent Mortgage?

It was in the 1880s that long-term interest rates hit 3.5 percent, something we may soon see with mortgages.

Mortgage borrowers are now seeing home loans at not much more than 4 percent for 30-year, fixed-rate mortgages. And, reports HSH.com, 15-year loans are already below 4 percent.

The lower rates result in substantially reduced monthly payments. For instance, imagine that you borrow $100,000 over 30 years and the fixed rate is 3.9 percent. Your monthly cost for principal and interest will be $471.67. The same loan at 5 percent would have a cost of $536.82 and at 6 percent the expense would rise to $599.55.

Of course, to get these terrific mortgage rates you need an income, a problem for the 16 million or so people who are unemployed or “marginally attached” to the workforce. And, certainly, no lender will give you a loan if you’ve recently been foreclosed, even if the cause of your financial distress was the lender’s “affordability” loan product that lead to your demise.

Federal Reserve

Since 2008 the government has done everything possible to save a tottering and tettering financial system, meaning big banks and brokerages on Wall Street. Part of this effort has been to knock down interest rates to levels unseen by any living human being.

For instance, the Federal Reserve has just decided to spend $400 billion to swap three-year Treasury securities for securities with a longer term, from six to 30 years. This maneuver shuffles the financial deck while not creating a single new job.

This has been great for the financial sector, which gleefully charges 29.9 percent for credit card debt while it borrows money through the Fed at near zero percent.

Taxes

There is now a serious proposal in Washington which would raise taxes on those who have benefited most from society. Some, however, oppose the idea because they feel it’s a form of “class warfare”.

“There’s class warfare, all right,” Warren Buffett told the New York Times, “but it’s my class, the rich class, that’s making war, and we’re winning.”

“This is not class warfare,” says President Obama. “It’s math.”

Meanwhile, major US corporations continue to generate massive profits — and pay little or no taxes.

GE, says the New York Times, “reported worldwide profits of $14.2 billion, and said $5.1 billion of the total came from its operations in the United States. Its American tax bill? None. In fact, G.E. claimed a tax benefit of $3.2 billion.”

US corporations now have some $1.5 trillion in overseas profits sitting outside our borders. This money could be used to modernize American factories and create millions of jobs but patriotic American companies will not bring the money back to the United States unless their overseas profits are taxed at just 5.25 percent.

Pensions

There is also much debate regarding the Social Security system, but little has been said about how the Fed’s efforts to help the financial sector have destroyed pensions.

Imagine that you had $2 million in retirement cash and invested it today in five-year CDs. Your likely interest rate would be roughly 1.75 percent or $2,915 a month.

But ask yourself: How many people have $2 million in retirement cash? Or $1 million? $100,000? In fact, the median amount set aside for retirement is just $45,000.

Truth is we all want interest rates that are higher than what we have today. Higher rates suggest the economy has begun to return, capital is more in demand, jobs are being created, homes are selling and savings are producing decent returns — things that help everyone, even folks not on Wall Street.

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The Illusion of Mortgage Assets

With newsstands dominated by scary headlines, Hollywood break-ups and still more diet plans, Harper’s magazine is typically somber and understated. However, for those with an interest in real estate the May 2006 issue offered a jarring cover story that’s tough to ignore: “The New Road to Serfdom: An illustrated guide to the coming real estate collapse” by Michael Hudson.

Using 20 illustrated steps, Hudson explains some of the conditions which will lead many households into a lifetime of debt and too many others into an inevitable pit of foreclosure and bankruptcy. He acutely understands that “affordability” today is too often measured in terms of monthly payments rather than overall debt load.

“Why is the demand for mortgage debt so high?” he asks. “There are several reasons, but all of them have to do with the fact that banks encourage people to think of mortgage debt in terms of how much they can afford to pay in a given month — how far they can stretch their paychecks — rather than in terms of the total amount of the loan.”

The problem, of course, is that for too many borrowers paychecks are essentially fixed while monthly mortgage costs are not. If interest rates rise — or if loans automatically convert from low “start” rates to bigger payments in three — five or seven years, then many owners will face one of three realities:

  • They will not be able to sell at a profit or a break-even basis (because prices will have declined as more homes come on the market);
  • They will not be able to rent at a profit or a break-even basis (because too many owners will try to rent unsold units at once); and
  • They will not be able to hold (because monthly payments will be crushing).

At first it may seem as though the inability of someone to pay their loan is a problem just for those who bought and financed imprudently. However there are other parties who will be impacted, not a minor matter since one of those parties may be you.

Even if you’ve been financially cautious to the point of absolute boredom, the value of your property does not exist in a vacuum. If a few additional homes above the norm in your neighborhood are foreclosed, if they sell at distressed prices, guess what happens to the value of your home?

It’s not just homeowners who will suffer if there are price declines. Lenders too will be walloped by the marketplace.

At the 2006 annual meeting of BerkshireHathaway, billionaire investor Warren Buffett gave his usual clever and insightful performance before investors.

According to Money magazine, Buffett said with regard to lenders and their annual (10K) reports that “dumb lending always has its consequences. It’s like a disease that doesn’t manifest itself for a few weeks, like an epidemic that doesn’t show up until it’s too late to stop it. Any developer will build anything he can borrow against. If you look at the 10Ks that are getting filed and compare them just against last year’s 10Ks, and look at their balances of ‘interest accrued but not paid,’ you’ll see some very interesting statistics.”

In other words, there’s no value to a loan which potentially produces a lot of interest if the interest is not actually being paid.

The issue, of course, is that a nonperforming loan secured by a property which has lost value or cannot be quickly sold or rented is not an “asset” in the usual sense of the term. Instead, nonperforming loans are a financial albatross that when spotted can undermine balance sheets, valuation models and stock prices — something that no doubt interests Buffett and other investors.

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Published originally by Realty Times on May 16, 2006 and posted with permission.

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